by Tim Sharp,
As the summer months draw to a close, and the cooler temperatures begin to set in, September saw the Fed pause, signalling that the sustained period of interest rate rises may also be approaching an end. Indeed, officials are hoping that policy is now ideally positioned to cool the sweltering inflation we have seen over the past 18 months, without strangling the economy.
Following the rapid rises in interest rates over the past two years, that has seen the FOMC hike 11 times and an incredible 14 consecutive rate increases from the Bank of England, this month potentially indicated a shift in central bank policy.
Looking at the Cleveland Fed’s inflation nowcast (an estimate of current inflation) suggests that core CPI in the US is running at 4.17% YoY[i]. Whilst this is certainly too high for comfort, it does represent a marked decrease from the highs of 9.1% reached in 2022. UK inflation remains a relative outlier in developed markets, with the latest CPI print at 6.3%.
If inflation is still a problem, why pause?
Whilst central banks have taken their foot off the gas…for now at least! We see the messaging as clear; the fight against inflation is far from over. Interest rate increases have a lagged effect, and it does take time to filter through to the broader economy. In our view, this along with greater uncertainty has convinced policy makers that pausing to assess the impact on the economy is the best course of action.
We feel that although rates are unlikely to rise much further from here, the overall tone of policymakers was hawkish. This was in large part due to greater emphasis that rates aren’t going to be coming down anytime soon. Given the continued resilience of the consumer – to the disbelief of many – and the ongoing inflationary risks, we think that central banks have been trying to persuade markets that rates will remain elevated for the foreseeable.
What does all this mean?
With regards to the current higher for longer narrative, we’re not entirely convinced. This will largely hinge on the ongoing strength of the economy. A central assumption being that economic growth will remain robust enough to justify the current rate environment. In our view central banks trying to regain their credibility after the rampant price increases of last year and aiming at all costs to stop higher inflation expectations becoming embedded.
We see signs that longer term expectations are shifting with longer dated government bond yields climbing and the yield curve beginning to steepen. The performance of treasuries over the month was a good example of this, with yields on the 10Y up 10% compared to only 4.1% for the 2Y. This in turn should further raise borrowing costs, tighten financial conditions, and ultimately help cool the burgeoning demand that has driven prices higher in our view.
This can also be seen in currency markets with the dollar continuing to strengthen. The Japanese yen notably continuing its weakness – down 2.35% over the month and 13.49% YTD – as the BoJ pursues a “golden opportunity to dispel the deflationary mindset”.[ii]
So, prices should start to come down?
A significant amount of progress has been made in bringing inflation back towards the two percent target, set by most central banks. However, we see two big ongoing risks that that will keep policy makers awake at night. Wages and energy costs! Meaningful inflation that persists over long periods – as was seen in the 70’s – has historically been driven by elevated wage growth, evolving into a vicious wage-price spiral. The latest data show’s UK wage growth at 8.5%[iii], a figure that we expect will certainly concern the BoE.
Adding fuel to the fire, the ongoing efforts of OPEC to avoid a capitulation in the oil price have been taking effect. Over the past three months WTI crude oil prices are up over 30%. Where falling energy prices had been a detractor for much of the year, they are now a meaningful contributor.
Whilst a win in the battle against inflation, the most recent PMI figures will provide little consolation. September services PMI data for the UK came in at 47.2[iv] – a figure below 50 representing contraction – with similar figures seen around the Euro area. The US marginally managed to buck this trend, with the PMI’s coming in at 50.2, showing continued expansion.
How does this affect markets?
Looking more closely at markets, September has been a challenging month. Except for the UK, all major equity markets are down over the period. History tells us that rising rates are usually bad news for asset prices. As was seen in 2022, if markets are digesting higher rates over the longer term, then the future profits companies can return to us as shareholders, have a lower value when discounted back to the present.
This is notable when looking at the dispersion of returns over the month. The fast growing, tech heavy Nasdaq has been the worst performer in September – down 4.97% at the time of writing – this makes sense, given much of the value these companies will be able to return to shareholders is likely to be captured far in the future.
The painful performance has not solely been confined to technology with many other broader equity indices and geographies suffering. The S&P 500, DAX and Nikkei delivered -5.22%, -4.33% and -0.93% respectively.
In addition to this, as the return offered by lower risk assets becomes more attractive, investors may be incentivised to de-risk their portfolio’s, we believe this could provide a headwind to risk assets going forward.
This all sounds quite gloomy?
Storm clouds have been gathering on the horizon for some time now and given investors plenty of reason to be cautious. Our positioning has reflected this. However, we see much of the strong performance of markets this year having been driven by the enduring resilience of the economy. Indeed, the Fed more than doubled their 2023 GDP projections from 1% to 2.1%[v]. This is a stark contrast to the 100% percent probability of a US recession by October 2023 forecast by Bloomberg economics last year.[vi]
Markets are forward looking, and although sentiment has been improving, a lot of good news is reflected in prices. US valuations are high by historical standards. The CAPE Shiller PE – a cyclically adjusted ratio for the price multiple on earnings – currently stands at 29.5 for the S&P 500, compared to a historic average of 17.1[vii].
Conversely, in the UK where investor sentiment is particularly negative, we believe valuations are far more reasonable. Whilst the backdrop remains challenging globally, there continue to be companies that offer value. We are confident that attractive returns are available to long term investors through a disciplined and diversified approach.
References, research by Alex Hulkhory: